By Donald S. Davidson -- On May 1, the California Department of Corporations announced that it is abandoning—for the time being—a proposal to require certain California investment advisers to register with the Department. Thus, California will remain one of the few states (along with New York and Connecticut) in which most hedge fund and private equity fund advisers located or doing business within its borders are not required to be registered with that state's securities regulator.
On Oct. 12, 2007, the Department announced plans (the “Proposed Amendment”) to amend California Corporate Securities Law of 1968 (“CSL”) Rule 260.204.9 to require any person who meets California’s definition of an “investment adviser” to obtain a license from the Department if the adviser: a) has a place of business in California or has six or more “clients” in California; and b) is exempt from registration with the SEC by virtue of the so-called “de minimis exemption” contained in Section 203(b)(3) of the Investment Advisers Act of 1940 (“IAA”). Advisers to venture capital companies would have been exempted from registration under the new rule.
After reviewing the public comments that it received and considering “ongoing actions by federal regulators,” the Department concluded that the Proposed Amendment was “premature” and decided not to proceed at the present time. As a result, hedge fund, private equity fund and other advisers that operate in California will not be subject to new licensing requirements by the Department for the time being.
Background and Brief History
Section 25009 of the CSL defines an “investment adviser” as “any person who, for compensation, engages in the business of advising others . . . as to the advisability of investing in, purchasing or selling securities. . . .” Section 25230 of the CSL requires investment advisers to register with the Department unless they are exempt. CSL Section 25202, adopted in 1997, provides that an adviser is not subject to registration if the adviser does not have a place of business in California and had no more than five California clients during the preceding 12-month period. An adviser who failed to meet both conditions would be required to register with the Department unless the adviser was registered with the SEC under IAA Section 203(b).
In 2002, the Department adopted Rule 260.204.9, which exempts any investment adviser from the registration requirements of Section 25230 if the adviser:
1. does not hold itself out generally to the public as an investment adviser;
2. has fewer than 15 clients;
3. is exempt from SEC registration by virtue of IAA Section 203(b)(3);
4. and either: has assets under management of at least $25,000,000; or provides investment advice to venture capital companies only.
The Department’s Statement of Reasons supporting the original adoption of Rule 260.204.9 made it clear that the intended beneficiaries were advisers to venture capital companies. However, the use of the disjunctive “or” in subsection (4) allowed other advisers to be exempted from registration if they met conditions (1) through (3) and had assets under management of $25,000,000 or more. Satisfying conditions (1) and (3) is usually easy for hedge fund and private equity managers. Subsection (2) also is generally not a problem since CSL Section 25202(b) borrows the federal definition of “client” used in IAA Section 222(d) and IAA Rule 203(b)(3), which counts the fund itself, rather than the individual investors in the fund, as the “client” for purposes of IAA Section 203(b)(3). As a result, hedge fund and private equity managers could avoid registering with the Department if their funds were large enough.
Nor, at that time, did federal law require most hedge fund and private equity managers to register with the SEC, because they were able to rely upon the “de minimis exemption" set forth in IAA Section 203(b)(3). That exception applies if the adviser: (i) had fewer than 15 “clients” during the preceding twelve months, (ii) does not hold itself out generally to the public as an investment adviser, and (iii) is not an adviser to any investment company registered under the Investment Company Act of 1940. As noted in the preceding paragraph, IAA Rule 203(b)(3) allowed managers of pooled investment vehicles organized as limited partnerships to treat the partnership itself, rather than the limited partners who invested in the partnership, as the “client” for purposes of IAA Section 203(b), provided that the adviser was not taking individual investor objectives into account in managing the fund.
There things stood until 2004 when the SEC adopted IAA Rule 203(b)(3)-2, which required many hedge fund advisers to count each individual investor in their funds as a separate “client” for purposes of determining whether SEC registration was required. This was a reversal of the SEC’s prior position and was intended to require virtually all hedge fund managers to register as investment advisers. The SEC’s effort, though, was short-lived. In 2006, the U.S. Court of Appeals for the D.C. Circuit vacated IAA Rule 203(b)(3)-2 in Goldstein, et al. v. SEC, holding that the SEC’s reversal of its position on counting hedge fund investors as individual “clients” solely for adviser registration purposes was both arbitrary and unsupported by the IAA. Consequently, hedge fund advisers are once again exempt from federal registration requirements if they meet the standards of IAA Section 203(b)(3).
The Department’s Proposed Amendment to Rule 260.204.9
The Department’s proposal to amend CSL Rule 260.204.9 was an attempt to require the registration of hedge fund managers who are no longer subject to federal regulation due to the Goldstein decision. The Proposed Amendment would have eliminated the 15 client cap and the $25,000,000 minimum assets provisions so that Rule 260.204.9 would exempt from Section 25230 registration only those investment advisers that:
1. do not hold themselves out generally to the public as investment advisers;
2. are exempt from SEC registration by virtue of the de minimis exception carved out by IAA Section 203(b)(3);
3. and provide investment advice to venture capital companies only.
Thus, under the Proposed Amendment, investment advisers other than those that advise venture capital firms only would have been required to register with the Department if they are: a) not registered with the SEC; and b) either have a place of business in California or have more than five California “clients.”
As noted above, after digesting the public comments on its proposed amendment and further considering ongoing actions by federal regulators, the Department has determined that proceeding with the Proposed Amendment at the present time would be premature.
The Proposed Amendment would have eliminated one advantage that California currently enjoys in attracting and retaining hedge funds and private equity funds. By shelving the proposed rule change, the Department has wisely decided to take a “wait and see” approach that will preserve its options while allowing it to monitor rapidly changing developments in the hedge fund arena.
Donald S. Davidson is a partner at Bingham McCutchen. Davidson is an experienced securities lawyer who handles a wide range of matters for broker-dealers, investment advisers and investment companies. He has represented clients in litigation and in regulatory inquiries involving the SEC, FINRA and its predecessors, Department of Justice, state securities regulators, and foreign securities regulators.